Soaring stock markets, which have become detached from underlying values, were another sign that unjustified exuberance had replaced last year’s overly pessimistic reaction to political events such as the US election and the UK’s Brexit vote, BIS cautioned in its annual report published on Sunday.

Claudio Borio, the chief economist at the BIS, welcomed a turnaround in global growth over the past year that had “strengthened considerably and [was] forecast to return to long-term averages soon”.

He said: “Economic slack in the major economies has diminished further; in some, unemployment rates have fallen back to levels consistent with full employment. And inflation has moved closer to central bank objectives.”

But he warned that financial markets and policymakers were too quick to forget the risks that brought about the 2008 financial crash. The disconnect between the exuberance of stock market investors and bond investors who lend funds to nation states was also a destabilising factor.

“There is tension between stock markets, which have soared, and sovereign bond yields [the interest rate on the debt], which have not risen much as economic prospects have brightened. And, unfortunately, the unwelcome long-term developments we termed “the risky trinity” in last year’s report are still with us: unusually low productivity growth, unusually high debt, and unusually narrow room for policy manoeuvre,” Borio said.

“Leading indicators of financial distress point to financial booms that in a number of economies look qualitatively similar to those that preceded the great financial crash.”

On the whole, the BIS annual report is a lot less alarmist than the Guardian article makes out. But there are others in the press and financial industry that are voicing concerns about problems up ahead in the global financial system.

Richard Bove of Rafferty Capital disagrees with Janet Yellen and writes that the next financial downturn could be far more devastating that the previous one and says that “The financial system is now at massive risk” because financial regulations now prevent the government from bailing out a struggling bank, meaning that the bank may have no choice but to fail. Bove argues that the very regulations put in place after 2008 could in fact be the destabilising factor that leads to the next big downturn.

Bove Ass Backward

Bove is correct about a potential crisis, but he has things ass backward.

We are in this mess because the Fed and governments have repeatedly bailed out banks on the moral hazard grounds known as “too big to fail”.

Dilemma of Transparency

The BIS Annual Report is lengthy but it’s worth a scan. Here are a few snips regarding the Fed’s communication tactics and balance sheet normalization.

The combination of gradualism and transparency raises a dilemma. It can certainly dampen volatility in the short run. But, if pushed too far, it may raise the risk of a larger adjustment and unwinding in the longer run.

This dilemma is especially visible in the context of balance sheet policies – how central banks decide to normalize the size and composition of their balance sheets.

The 2013 taper tantrum and the associated communication difficulties are still very much on policymakers’ minds.

Other, novel challenges have more of a political economy nature. Large central bank government bond purchases when rates are unusually low will entail losses precisely when the policy succeeds; that is, when the economy and inflation recover. The corresponding losses can lead to unwarranted public criticism and even threaten the central bank’s autonomy.

The normalization of monetary policy in the major economies also has implications well beyond their borders. Developments in the past decade have shown that monetary policy spillovers can pose complicated challenges for central banks and disrupt adjustments in the global economy.

More Tightening than Priced In?

Via email, Albert Edwards at Societe Generale also commented on the BIS article asking “20 years since the Asian Crisis, has anything really changed?”

On the 20th anniversary of the start of the Asian crisis, it is certainly clear to me that the mess we are now in is a linear progression of the monetary madness that followed the 1997 Asian bust. Each and every subsequent economic and financial hiatus has been a direct result of excessively loose monetary policy to clear up the previous mess. The current perilous state of the global financial system is evident to anyone who scrapes at the cheap veneer of normality. I was cheered last week when the BIS called out the current conjuncture. They were one of the few institutions in the mid-2000s to accurately predict the impending financial crisis – and they fear another crisis is close.

Unlike central banks who merely give a casual shrug of the shoulders when asked about the impact of their ZIRP and QE policies on debt and asset bubbles, the BIS is really very concerned that policy makers are making exactly the same mistakes they did in the run-up to the 2008 financial crisis. In what can be regarded as the clearest warning possible, if not a direct rebuke to current central bank timidity and gradualism, the BIS Chief Economist, Claudio Borio said “The end may come to resemble more closely a financial boom gone wrong, just as the latest recession showed, with a vengeance. A strategy of gradualism is no panacea, as it may encourage further risk-taking.”

He went on, “Leading indicators of financial distress point to financial booms that in a number of economies look qualitatively similar to those that preceded the great financial crash.”

[Mish Comment: Those quotes are not in the annual report but others are also citing Claudio Borio.]

I, like many others, have been scratching my head as to what really has changed in its thinking from this time last year. Certainly not the data!

[Mish Comment: Count me among those who have stated Fed hikes are unwarranted by Fed measures since the Fed ignores asset bubbles.]

John Mauldin writes in an appropriately titled piece Mad Hawk Disease Strikes Federal Reserve, “I believe a faction on the FOMC wants to cement its own preferred policies in place and make it difficult or impossible for a new majority to change course in 2018 or thereafter. Yellen, Fischer, and Dudley all seem to be of that mind, and they are now taking a hawkish approach to monetary policy. That’s why they don’t want to do the otherwise sensible thing, which is to wait for more evidence that inflation is a problem before tightening further.”

[Mish Comment: The sensible thing is to not blow bubbles in the first place. Mauldin also insinuates more inflation is a good thing. It isn’t.]

An alternative theory is even more desperate for investors. My learned counterpart Michael Harnett at Bank America Merrill Lynch believes that the Fed has become increasingly concerned about the inequality QE has produced. It had been willing until recently to run the economy hot in the expectation that this would produce wage inflation for Joe Sixpack. That hope has been disappointed and “the Fed has two ways to cure inequality…you can make the poor richer…or you can make the rich poorer…”. And recent events make Michael think the Fed has now abandoned the former and opted for the latter.

If Michael and/or John Mauldin are right, there are going to be some very surprised investors out there.

Mish Theory

Does the Fed, in aggregate, believe it blew a bubble? Of course not, even if a couple Fed members believe that may be the current direction.

Is this a transfer of wealth conspiracy theory of some sort, with the Fed actively seeking a transfer of wealth from the poor to the rich.

Many believe that theory, but it is directly opposite Michael Harnett’s inequality theory.

A simpler explanation, my theory, and the theory that best meets Occam’s Razor is the Fed has no idea what it is doing.

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54 thoughts on “Rethinking the Fed: More Tightening than Priced In? Next Financial Crisis Coming Up?”

The Fed at first had only a historical-based belief that its policies would deliver a sustainable economic recovery “as expected.” And it didn’t pan out. It thought its QE stimulus would catalyze business investment, and it didn’t. It then thought that by holding out for a sufficiently long-enough time we would see some sort of economic white-swan swoop in and catalyze the sustainable economic recovery it expected. And that didn’t happen either. Time’s up.

“Is this a transfer of wealth conspiracy theory of some sort, with the Fed actively seeking a transfer of wealth from the poor to the rich.”

Every penny of new lending, and other money supply growth, does provide some sort of stimulus effect on activity. So you do get an increased short term nominal GDP from it. Hence increased short term employment readouts. Both of which are major goals for the Fed.

If the Fed dumped all this new money into the hands of the middle classes, they’d spend it largely on stuff that comprises the CPI. So the Fed’s favorite measure of “inflation” would increase, offsetting the nominal growth above.

By distributing the new money via debt, hence to those in the financial sector and those who are already wealthy, the Fed gets to have it’s cake and eat it, too. It can pump up nominal GDP with fresh print, but all the money goes to people who don’t spend much of it on CPI components. But rather on so called “assets”. Hence, nominal GDP up, while CPI “Inflation” stays dormant. So it looks like “Real GDP” increases, “inflation” stays subdued, and “employment” is up.

If you are a hard Aspie, for whom “managing the economy,” consists of optimizing the three above abstract measures, without giving even half a toot as to how any of them map (more like don’t map) to anything practical in the real world, it looks like you, in all your brilliance, have just come up with some sort of economic perpetual motion machine. And the above pretty much describes the crowd over at the Fed: Ever so busy with abstract optimizations of measures, without ever bothering to recognize none of their chosen measures mean anything in the real world anymore.

So No. Not evil. Just clueless, completely detached from reality, and neither aware nor concerned that that is all they are.

Weimar put the money in the hands of workers and could not keep up with resulting inflation, via debt they can tighten from behind the scenes, but the endgame heads in the same direction once rates are so low that everything is poorly priced and government spending accounts for a large part of the obliged national wage.

Wrong, it was not until Hitler that money was put in the hands of the people, it was then that the banks were made to serve the people bringing prosperity, and Churchill in 1936 was bought to seek war to the advancement of the internationalist, known as the globalist today, the victors of WW1 & 2.

I will try to dig up some of the detailed research I have read that points to the micro economic reasoning, that compares national debt levels including reparations, etc. It is not at all as clear the notion you propose, though I don’t doubt there was a lot of power politics at play in the international finance and monetary policy of the day. Ray Dalio produced a detailed analysis ( and not the one found easily online), plus there are other historic documents on the domestic policy. Hitler embodied state control to the most “effective” degree maybe, but the policy of union and price support was in place before his time I think. If I find the documents/links I’ll come back and post them here to you at some point… I have to search through old archives on different computers to locate them now.

A Weimar like development is what the Fed thinks they have found a way to avoid, while still being able to print money just like they did back then. I.e, they think they have created the equivalent of an economic perpetual motion machine: Print as much as we want, as long as the money is handed to people with low propensity to spend in on whatever arbitrary goods we include in our harebrained “inflation” calculation.

Never mind that while loaves of bread may have cost millions in Germany anno then, in America anno now, pieces of paper with 20 different five-years-late Snapchat clones’ names on them, cost billions…. Despite none of them ever having much prospect of ever generating enough income to buy even a more modesltly priced bread loaf.

And ditto for a roof over ones head in many parts of America…

And so on and so on…

And as more and more people does take heed of the distorted price signals the Fed’s policies are sending, more and more stop doing anything productive, and instead focus on getting in on the rackets.

Until everyone, from government on down, is doing nothing but either trying to skim percents from every “asset” sale and transfer the fresh print beneficiaries can be coaxed into performing, acting as simple hand servants for ditto, weaseling around trying to get the politico-legal “system” to force some rich yahoo to hand them something, or cooking up ever more ridiculous get-richer-quick schemes to fool the anointed into dumping some of their Fed-welfare into. Noone bothers doing anything hard, difficult, risky and genuinely productive, since the risk/reward isn’t even close to what can be had by just getting in on the rackets, trying to grab a share of the flood from the Fed.

The Fed as always is riding a tiger (asset prices) and now it badly wants to dismount. The catch is it has been riding it for too long (since 1987) and may find it a wee bit difficult to dismount. My fond hope is it gets eaten up in the process.

Another factor in volatility is temporary employment. This article could apply to any other country – where repayment of debt is tied to being able to renew work frequently, works until not, and wages become variable. Here Spain saw its biggest one day drop of registered workers ever, and at the start of the temporary summer season as opposed to towards the end… 250 000 registered jobs lost in one day:

“A simpler explanation, my theory, and the theory that best meets Occam’s Razor is the Fed has no idea what it is doing.”

And it persists because those in a position to publicly call for and demand a change, the owners of governments and governments themselves, are the ones benefiting from it. Meanwhile, the VAST majority of the public worldwide don’t even realize there’s a problem, only sensing its results via a decrease in their standard of living and, even if they did know the root cause, wouldn’t have the first clue about what should be done about it.

1- politicians understand finance even less than econ people understand finance.

2- Wouldn’t you want a scapegoat between you and the populace if you were a politician. Why be the one responsible for economicy stuff if someone else can be pointed at. Trading firms as well, if you ran a giant bank would you want the populace pointing at you or the Fed?

That said, the Fed does little to nothing positive or negative, they just pretend to.

Positive and negative are ultimately subjective… it is like trying to assign responsibility where someone tells you it is destiny, in philosophy you will only find choices of perception.

In the real world though, to an individual who has the right to never adhere to or use the financial construct, he or she won’t hesitate in accusing or laying blame if they feel they have lost out. Government and FED know this, use it for political effect, and as reasoning in their decisions, being sure they and their closer associates gain most from the phenomenon.

Sure the FED has a positive/negative effect by its existence, and it won’t be judged by balance sheets but by resulting social structure and decision.

Market forces, demographics, debt etc. are too complex to control by simple interest rate adjustments or loosening or tightening the money supply. The fed along with others are finding themselves ineffective and obsolete.

Mish, you are absolutely correct in my opinion, that the Fed has no clue what it is doing. The lesson it has learned since the Asian Crisis, is that loose monetary policy re-liquifies asset markets. So, we can be certain that the next QE is on deck. When asset markets swoon and leveraged players squeal, the Fed will buy financial assets at the highest price. Look at what the BoJ is doing with JGBs. It essentially owns the market.

Mish correct? Inflation is always a conspiracy. The knowing theft and transfer of wealth benefits those who perpetuate it. The fed is a puppet! It knows exactly what it is doing because it is controlled by its puppet master Wake up people.

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

~Ludwig Von Mises~

The CB’s have to raise rates, they have no choice. Years ago the pensions industry used in their model a 6 to 8% interest rate which historically was the norm back then. For over a decade now with interest rate suppression these pension funds have been taking on water. Also it has forced pension fund managers to take on riskier position in the search for yield. Here in the UK the estimates are that these pension funds are about 800 billion short and should the bond bubble burst, which it will, many people good end up with nothing.

Its the pension funds’ fault that they modelled for nominal GDP growth that couldn’t possibly exist. Pension funds were broken by design, not broken by central banks. Although pension fund managers, who have been helping themselves to assets of the plans, certainly will try and use the central banks as scapegoats.

HI Mark. I agree that if a pension fund is poorly run, it will end up in trouble (just like a poorly run business). Can you back up your claim that pension fund managers are “helping themselves to assets”? I understand that pension fund managers earn a salary and a performance bonus, but what you imply is illegal. Do you have any evidence?

Second; I have assumed from some of your posts that you might be Canadian; and from my research it appears that the vast majority of Canadian pension funds are very well run and fully funded or in surplus. Were your comments about US pension funds exclusively or pension funds in general?

Civil unrest. Seems a possibility in the next downturn. Crisis always bring about some mechanism of ownership transfer thats done well outside the confines of a market based system. Our system, however, is not market based due to the credit flow. The era of broken promises may indeed be upon us if the corporate bond market breaks down. This would leave only the sovereign debt market to generate cash flow for the economy. Sovereign market already too large relative to GDP. Equity financing underwritten by CBs will be needed to generate cash flow to “stabilize prices.” Monetization by any other name. If we get the bond bust can they act fast enough and large enough? There simply are not enough assets to satisfy the claims. And that was exacerbated by QE not narrowed. Its biggest failure.

The answer to the quest for yield is the “gray” marijuana market. Because marijuana is still illegal under federal law, green businesses can’t obtain financing through banks. Therefore, they have to raise private capital. A friend of mine is meeting this weekend with a dispensary entrepreneur in a state that just legalized recreational marijuana — the startup is negotiating 100% interest per year for three years on the investment. That’s some insane yield, but there’s probably no security or collateral backing the investment.

Pension funds need to get 100% invested in recreational marijuana while it’s still illegal under federal law.

Yes, that’s a joke (although the part about my friend investing is absolute truth). Shows you exactly how f***ed pension funds are.

The market is doing the exact opposite of what the Fed thinks should be happening. So expect the Fed to tighten faster and harder than anyone expects. And that will be what pops the bubble. Dangerous waters ahead!

Nothing has changed. The economy remains dependent on credit issuance to generate new cash flow for growth. As long as fiscal growth is allowed the economy won’t move into recession. The problem of course in the hall of mirrors is that the leverage ratio accelerates from the diminishing returns effects. Without QE the market will have to re-price new issuance to reflect CB absence. Do banks have enough fire power to underwrite the massive issuance that must occur to expand the economy? Are the CB’s risking an asset bust that derails the economy? Possible. Credit growth has already slowed to stall speed/recession type levels. An an of Q/E and a market anticipating a B/S wind down could be the event that knocks these asset markets down and with it the corporate bond market. The corporate bond market is collateralized by equities due to the massive buy backs. The corporate bond market is where the excess of the latest record expansion lies. It is a significant source of new cash flow for the economy. If an asset bust creates an issuance drought there, the asset price decline could intensify as it reflects on itself. Should it crumble how is the corporate bond market bailed out? No GSE there to bring onto government B/S. A collapse in corporate bonds is the problem that could be difficult to defuse.

The economy is what “actually goes on” . Is what is going on actually expandable in a positive sense, or is it just people doing “anything” to get hold of cash to pay their debt? At a certain point it becomes more invention than necessity, it becomes frivolous rather than maintenance of necessary structure.

The whole balance of sentiment revolves around a credibility that might vanish when the promises it displays are seen to be empty.

Completely agree. An era of broken promises is upon us. The broad kick the can trend is simply manifest in an ever widening systemic asset liability mismatch that can never be allowed to retrench. It will unfortunately.

Some good points, credit growth crashing is ominous indeed as fiscal growth too small to compensate. But corp buy backs put more money in the hands of people that don’t spend but want to save, so they either bid up other equities or bid up bonds, some of which are corp. this source of new money goosed equities but not the real economy…
The end of corp buybacks will accelerate and deepen the crash because falling equities will kill optimism and spending among most income groups.just like last time… and as noted, credit growth is crashing, likely this already means less buybacks.

Always focus on the big picture my friends
Fact is we re in a long term bullish market so enjoy to ride the trend
Don t fight the Fed but trust the fed instead as they know what they are doing in the FOMC
Janet Yellen is brilliant and has done a great job so far being nice to us retail traders managing the institution correctly so that US stxx markets remain stable
Don t believe newsletters on the web pretending it s gonna be the end of the world etc…
Focus on trading stxx ie buying losers and selling short laggards
I am long only being very careful

Of course, you have no idea who are leaders and who are laggards. You as in everyone. Up to and including Warren Buffet. If you did, you wouldn’t be allowed to buy or sell them anyway, as that would be insider trading.

What you are really doing, is myopically running around believing you have found a “system” for predicting lotto numbers. Which can look good enough to the less that reflective, as long as the Casino lets you play with a 55-45 edge.

Which they can do, as long as they can count on your support in their primary mission: Robbing those not playing, for more than they have to pay you to support them in that act. That’s what the whole “ownership society” nonsense is all about, after all: Making compliant, sycophantic, establishment apologist stooges out of as many as possible; then rewarding those who most enthusiastically and uncritically perform stooge duty as directed, with loot stolen from those a bit more apprehensive.

Of course, as the Lady said, sooner or later they, hence you, will run out of other people’s money..

The bank may have no idea how to centrally plan an economy, but the result of printing is still bank confiscation of goods from the average person. Printing is confiscation, regardless of what wacky theory is used to distract the sheep from their fleecing. Our ancestors used a gold standard to protect themselves from bank printers. Bankers never run out of excuses to confiscate stuff from the average person by printing inflation.

Actually, bankers are slowly confiscating my pension. I don’t have the option to receive it in gold coins. Bankers are also confiscating my future Social Security check, even before I start receiving it. Bankers are also confiscating the wages of my extended family, who don’t get paid in gold coins. We need a gold standard to protect us from bankers, like our ancestors had.

So, if I got hold of the printing press, printed myself a few quintillion dollars; then used some of those dollars to outbid everyone else, for every house, every lot of land, and every stock certificate and other security, sold in America for the next 50 years; hence ended up owning 80% of everything in the US; I would somehow not have confiscated some of all that, just because you were still allowed to buy a gold coin?

A blast from the past. Haven’t heard his name mentioned in several years.

10 years ago I never heard of him. But came to know his name well in the pre crisis days … on those days when bad economic news came out … markets would be wobbly / down … and then suddenly Dow would spike a 100 (or 200) points. Why? Well, a certain Mr Dick Bove had a habit of timing a bank (sector) upgrade for wobbly / down days.

Track record?

May 2008:

“Punk Ziegel’s bank analyst Dick Bove has issued another strikingly rational report that provides tasty food for thought. This one is entitled “Wait! Stop! Think!”. In it he argues that the media is fomenting hysteria about the situation in the banking industry, which in reality remains quite sound.”

I’m not sure what Bove is talking about. There will certainly be another financial crisis, but I seriously doubt it will be led by the banking sector. Financialization / shadow banking will be the culprits. Now, banks may well be taken out … but in “collateral damage” fashion.

OCC:

“In the end, the question is whether all of these collective efforts have made the financial
system stronger, more resilient, and more capable of meeting customers’ needs than it was heading into and during the crisis. We have every indication that the answer to that question is “yes.”

We see it on the balance sheets. Tier 1 common equity is nearly 13 percent of riskweighted
assets, up from 9 percent in the fall of 2008. The leverage ratio is now at 9.1 percent,
almost one-third higher than in 2008. And, liquid assets have achieved a 30-year high of
16 percent of total assets. America’s community banks are stronger too with return on equity
nearly recovered to pre-crisis levels, with loans growing steadily.”

Longer term interest rates, the important ones, are not controlled by the FED on a month to month basis. They react to the demand for credit and its supply. The problem has been the lack of demand. The big multi-nationals no longer need the banks, are cash rich and when short of money tap the wholesale market. The loss of their biggest customers is what forced the banks into the retail market offering mortgages, car loans, student loans, unsecured personal loans etc which now, with the exception of mortgages, exceeds in the aggregate the value of personal debt in 2008. They should have been allowed to fail in 2008 which would have led to a massive restructuring and downsizing of the banks. This is what will now happen in the coming financial blow up. And yes the rich will be a lot poorer, because the poor will not be willing to become even poorer to keep the rich, rich. All the FED did was buy time while the 0.1% bought land in New Zealand to build their luxurious bunkers.

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